Three letters – APR – can help you understand the ABCs of borrowing money with a credit card or another financial product. Follow along as we educate you about all things APR.
Credit cards and various types of loans come with APRs, or annual percentage rate. This is also referred to as credit card interest or an interest charge.
For credit cards, the APR is what you’ll wind up paying if you don’t pay off your monthly balance and you carry over the debt to the next month. A credit card APR does not include fees and other costs.
On the other hand, the APR for mortgages, auto loans, student loans, personal loans and other lending products typically includes fees and additional costs.
APRs for credit cards and other lending products fluctuate from lender to lender and from borrower to borrower. APRs are also based on your credit score and other factors. The better your credit score, the more likely it is you’ll a receive lower APR, which can translate into paying less to borrow money.
What is APR?
APR stands for annual percentage rate. It refers to the annual cost of borrowing money, either with a credit card or a loan.
The interest rate is the basic amount, shown as a percentage, that a lender charges you to borrow money. APR takes into account the interest rate along with any fees being charged.
For instance, a credit card might carry an APR of 16%, while a mortgage might offer an APR of 3.4%.
See related: What is the average credit card APR?
How do credit card APRs work?
Fortunately, when understanding how credit card APRs work, the math involved in calculating APR isn’t as complicated as you might think.
First, let’s look at how a credit card issuer calculates APR. For credit card interest rates, the calculation starts with an index. A popular index to use is the U.S. prime rate (or prime lending rate). This rate is 3 percentage points above the federal funds rate set by the Federal Reserve, which establishes U.S. monetary policy. The federal funds rate is the interest rate banks and credit unions charge each other to lend money on an overnight basis.
A credit card issuer then tacks on a margin, which is the percentage added to the prime rate or another type of index. The margin is typically tied to your credit score. A higher credit score usually results in a lower margin.
How to calculate a credit card APR
So, let’s say the index – in this case, the prime rate – is 3.25%. If the card issuer assigns you a margin of 15 percentage points, then the credit card’s APR would be 18.25%. If you’ve got a card with a variable rate, a change in the index can send the credit card interest rate up or down.
Types of credit card APRs
Among all lending products, credit cards have the most varieties of APR. Loans typically come with just one kind of APR (although a homebuyer can get a mortgage with what’s known as an adjustable rate). Here are the types of APR you’ll come across with a credit card.
The purchase APR is the rate you pay when you make purchases with your credit card. It’s typically the lowest of the credit card APRs.
Cash advance APR
If you borrow cash with your credit card, you’ll pay the cash advance rate. It’s often higher than the purchase APR.
If you fail to follow the terms and conditions, a card issuer hits you with a penalty APR. For instance, card issuers frequently charge a penalty APR when you make a payment after the due date. The penalty APR is usually higher than the purchase APR or cash advance APR.
A card issuer frequently will offer an introductory or promotional APR for special purchases as well as balance transfers or cash advances.
For example, an issuer might dangle a 0% APR for a new card if you transfer a balance from another card and pay off the balance transfer within a certain period of time. If you fail to wipe out the balance transfer amount the allotted time, interest charges kick in.
See related: What happens when your 0% introductory APR ends?
What’s the difference between a fixed APR and a variable APR?
Remember that index we explained earlier? The index affects whether a credit card has a fixed APR or a variable APR.
A fixed-rate APR does not change when the index changes. But a variable APR does. The cardholder agreement for your card explains how the APR can fluctuate based on the index and federal interest rates.
What is a good APR for a credit card?
A good credit card APR is below the average APR. Keep in mind, though, that only people with excellent credit qualify for below-average APRs.
An above-average APR isn’t necessarily bad. But the higher an APR is, the more you’ll pay for purchases, cash advances and other credit card transactions – unless you pay off your balance in full every month, thus avoiding interest charges.
It’s important to know how credit card APRs work, but it’s critical that you pay your balances every billing cycle to avoid credit card debt. That way you’ll never be on the hook for interest charges, and you won’t pay more than the prices of the things you’ve purchased with your card.